JUDY ANN F.
GAZZINGAN
1. What is franchise? Discuss.
A franchise (or franchising) is a method of distributing products or services involving a
franchisor, who establishes the brand’s trademark or trade name and a business system, and a
franchisee, who pays a royalty and often an initial fee for the right to do business under the
franchisor's name and system. Technically, the contract binding the two parties is the “franchise,”
but that term more commonly refers to the actual business that the franchisee operates. The
practice of creating and distributing the brand and franchise system is most often referred to as
franchising.
There are two different types of franchising relationships. Business Format Franchising is the type
most identifiable. In a business format franchise, the franchisor provides to the franchisee not just
its trade name, products and services, but an entire system for operating the business. The
franchisee generally receives site selection and development support, operating manuals, training,
brand standards, quality control, a marketing strategy and business advisory support from the
franchisor. While less identified with franchising, traditional or product distribution franchising is
larger in total sales than business format franchising. Examples of traditional or product
distribution franchising can be found in the bottling, gasoline, automotive and other
manufacturing industries.
2. What are the steps in recognizing revenue from franchise contracts? Discuss.
Within the new standards there are five steps outlined for revenue recognition.
Step 1: Identify the contract with a customer.
This step will typically be straightforward for franchisors because they have a written franchise
agreement in place that specifies the parties, each party's rights and obligations, and the payment
terms. The agreement will also have "commercial substance," meaning the cash flows of both
parties are expected to change as a result of the contract. Franchisors must take the additional step
of determining collectability based on its credit underwriting of the franchisee.
Step 2: Identify the performance obligations in the contract.
Franchisors must determine if the services -- such as pre-opening activities, site selection and
training -- it provides to the franchisee at the onset of the franchise agreement can be identified as
"distinct" from the intellectual property that the franchisee is licensing. This determination should
be made based on professional judgment and industry best practices. (In many areas, including
this one, privately held franchisors can look at the filings of publicly held franchisors to see how
those businesses handled a determination.)
Step 3: Determine the transaction price.
For franchisors, this step involves listing all the revenue streams -- including those that will be
received up front, and those that will be received over time -- it will collect from the franchisee,
including the initial franchise fee, royalties, renewal fees, transfer fees, relocation fees and so on.
All revenue streams should be outlined in the franchise agreement.
Franchisors may also need to note significant financing components in arrangements in which the
timing of payment is extended or significantly later than when the goods or services are provided,
such as area development rights or master franchise rights. Additionally, non-cash services must
be valued as part of the transaction price at the inception of the agreement.
Step 4: Allocate the prices to the performance obligations
For this step, franchisors must take each distinct good or service determined in step 2 and assign a
transaction price at the inception of the agreement. One or more approved methods may be used to
make these determinations, including the adjusted market assessment approach, the expected cost
plus a margin approach, and the residual approach. The outcome for each item must be a stand-
alone value, meaning the value at which the good or service could be sold on its own.
Step 5: Recognize revenue.
For franchisors to recognize revenue for a particular good or service, that good or service must be
transferred to the franchisee, either at a point in time, or over time (over the period of the franchise
contract). Royalties have a carve-out exception as sales-based royalties; therefore the franchisor
continues to recognize them as the underlying sales occur, and accrues for royalties earned but not
yet received.
Another concept covered within this step is principal versus agent transactions, such as in the case
of an advertising or national marketing fund. If the franchisor controls how the funds are to be
spent, the monies collected for these funds are recognized as revenue in a manner similar to
royalties and expenses are recognized as incurred.
